Chapter 2: Risk and Return

2.1 Introduction to risk and return

2.2 Standalone risk and return
2.3 Risk and return of a portfolio
2.1 Introduction to risk and return
What is Return?
Ø Return is the net reward generated from an investment.
Ø It is a gain or loss made from an investment.
Ø Return is simply any cash payments received due to ownership.

Ø Expected rate of return is the weighted average of possible returns

from a given investment for the future

Pi= Probability, ri= return at each state of nature

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What is risk?

n Literally risk is defined as “exposing to danger or hazard”

q Which is perceived as negative terms

In finance,
Risk refers to the likelihood that we will receive
a return on an investment that is different from
the return we expected to make.

Hence, it is both bad outcomes and good

outcomes.
Risk is the variability of return because of different
uncertainties.
The followings are types of risks
1. Controllable Risks (Unsystematic Risks)
q Operating risk
q Liquidity risk
q Credit Risk
2. Uncontrollable Risks ( Systematic Risks)
q Market risk
q Interest rate risk
q Inflation risk
q Political risk
q Exchange rate risk
q Legal Risk
How Risk is Measured?

Using Probability Distributions to

Measure Risk

When you define the probability distribution of rate of

return remember that:
- the possible outcomes must be mutually exclusive and
collectively exhaustive
- the probability assigned to an outcome may vary
between 0 and 1
- the sum of the probabilities assigned to various possible
outcomes is 1
 Stand Alone Risk and Return
1. The standard deviation is an absolute measure of
risk. The smaller the standard deviation, the lower
the risk of the investment and vice versa.

2. Coefficient of variation is a relative measure of

risk computed simply by dividing the standard
deviation for a security by expected return:

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Exercise One – Equal Probabilities
State of the Probability of Security
Economy the state of returns if state
the economy occurs
X Y
Recession 0.5 -5% 15%
Boom 0.5 70% 25%

b. Risk Premium = Expected Return - Risk Free Rate

RPx = 27.5% - 6% Rpy = 20% - 6%
RPx = 21.5% Rpy = 14%
Exercise One- Equal Probabilities
C. Compute standard deviation
q relevant risk measure is the total risk of expected
cash flows measured by standard deviation
n The larger the standard deviation, the higher
the probability that returns will be far below
the expected return.
 Exercise One- Equal Probabilities
n Standard Deviation of Return – stock X
.
State of the Prob Return pixRi Ri – E(Ri) Ri – E(Ri)2 Pi*(Ri – E(Ri)2)
Economy (pi) (Ri)
Recession 0.5 -0.05 - 0.025 -0.05 – 0.275= 0.105625 0.0528125
-0.325
Boom 0.5 0.70 0.35 0.70 – 0.275 = 0.180625 0.0903125
42.5
0.325 0.1431250
 Exercise One- Equal Probabilities

n Standard Deviation of Return – stock Y

State of Prob Return pixRi Ri – E(Ri) Ri – E(Ri)2 Pi*(Ri – E(Ri)2)
the (pi) (Ri)
Economy
Recession 0.5 0.15 0.075 0.15 – 0.20= 0.0025 0.00125
-0.05
Boom 0.5 0.25 0.125 0.25 – 0.20 = 0.0025 0.00125
0.05
0.200 0.0025
 Stock X Stock Y
Expected Return, E(R) 27.5% 20%
Variance 0.1431 0.0025
Std. Deviation 37.8% 5%
Stock X has a higher expected return, but Y has
less risk. You could get a 70% return on your
investment in X, but you could also lose 5%,
notice that the investment in Y will always pay at
least 15%
Coefficient of Variation (CV)

n Stad. Dev. can sometimes be misleading in

comparing the risk, or uncertainty, surrounding
alternatives if they differ in size.

q CV = Std. Dev./ Expected Return

n The CV is a measure of relative dispersion (risk) – a

measure of risk “per unit of expected return.”
n The larger the CV, the larger the relative risk of the
investment.
Coefficient of Variation

• Using the CV as our risk measure, investment in

stock X with a return distribution CV of 1.37 is
viewed as being more risky than investment in
stock Y, whose CV equals only 0.25.

Stock X Stock Y
Expected Return, E(R) 27.5% 20%
Variance 0.1431 0.0025
Std. Deviation 37.8% 5%
Coefficient of Variation 1.37 0.25
Exercise Two - Unequal Probabilities

State of the Probability of the Security returns if

Economy state of the state occurs
economy X Y
Recession 0.6 -8% 15%
Boom 0.4 70% 25%
Example:
Consider the possible rates of return that
you might earn next year on a Br. 10,000
investment in the stock of either Marta
Products Inc. or Yonas Company. Calculate
1. The expected return of both stocks
2. The standard deviation of both stocks
3. The coefficient of variation of both stocks
4. Which stock is more risky?

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 Probability Distributions for Marta
Products and Yonas Co. stocks
Demand for Probability Rate of Return on Stock if
the of Demand the Demand Occurs
Products Occurrence Marta Yonas
Products Co.
Strong 0.3 100% 20%
Normal 0.4 15 15
Weak 0.3 (70) 10
Risk and Return in a
Portfolio Context
Portfolio Theory

The Principles of Diversification

► It is risky to hold a single financial asset in
isolation
► It is better to hold a group of securities in order
to minimize risk
► This group of assets held to gather are called
portfolio

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 Expected Return on a Portfolio
n The expected return on a portfolio is simply the weighted
average of the expected returns on the assets comprising
the portfolio.
n The portfolio return is the weighted average of the
returns of the securities
rp = w1r1 +w2r2 + … + wnrn

Or
E(Rp) = ΣwiE(Ri)

Where E (Rp) = Expected return on the portfolio

wi = Proportion of portfolio invested in security
E(Ri) = Expected return on security i
Example: Expected Return of Portfolio

n See Exercise 3
State of Probability of Returns (in %)
Economy state Stock A Stock B Stock C
Boom 0.40 10 15 20
Bust 0.60 8 4 0

n Condition a
Stock A = 8.8% * (1/3) = 2.93
Stock B = 8.4% * (1/3) = 2.80
Stock C = 8.0% * (1/3) = 6.67
8.40% E(Rp)
Example: Portfolio Return

n Condition b
Stock A = 8.8% * (0.50) = 4.40
Stock B = 8.4% * (0.25) = 2.10
Stock C = 8.0% * (0.25) = 2.00
8.50%
E(Rp)
Portfolio Risk of two asset
1) Portfolio risk is not the weighted average of
the standard deviation.
2) Portfolio risk can be minimized by diversification

  (wA) (A) (wB) (B) 2(wA)(wB)(A,B)(A)(B)

p
[8-15]
2 2 2 2

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Example:
A portfolio consists of assets A and B. The
return, the standard deviation, and Weight
of each of these securities is given below.
Calculate : The expected return on the
portfolio and the portfolio standard
deviation
a) When the correlation b/n A & B is +1
b) When the correlation b/n A & B is -1
c) When the correlation b/n A & B is 0

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Asset Weight Retur Standard
n deviation

A 1/3 18% 20%

B 2/3 9% 10%
Can we Diversify all Risks?
► Securities consists of two components of risk
1. Diversifiable (Controllable or unsystematic) risks
– Operating risk
– Liquidity risk
– Default risk
2. Non Diversifiable (Non controllable or systematic risks
• Inflation risk
• Interest rate risk
• Market risk
Total Risk = Systematic Risk + Unsystematic Risk

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
Unsystematic
Risk
Tota
l
Risk
Systematic
Risk

No. of
assets
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How to manage Systematic Risks
Capital Asset pricing Model (CAPM)

Where:
Ki=required rate of return
KRF = risk free rate (e.g. rate of t-bill)
Km = market rate of return
β = an index of non diversifiable risk

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q CAPM was discovered by William F.
Sharpe
(1934 – present)
q He is the 1990 noble prize winner
economist
Interpreting b
► β is a measure of the security volatility relative
to the average security in the market.
q if b  0
n asset is risk free

q if b  1
n asset risk = market risk

q if b > 1
n asset is riskier than market index

q b<1
n asset is less risky than market index

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Illustration:
Assuming that the risk free rate is 6% and
the market rate is 11%, calculate the rate of
return for specific security if the beta
coefficient has the following values and
draw the security market line
a. β=0
b. β = 0.5
c. β =1.0
d. β =1.5
e. β =2.0

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End of the chapter